Mutual funds

Mutual Funds

What is a mutual fund?

A mutual fund is simply a financial vehicle that allows a group of investors to pool their money together into a fund that will in turn be invested according to the funds investment objectives. In return for placing your money in the mutual fund you are given shares in, or part ownership of the fund.

Benefits of investing in a mutual fund

There are many index funds available to investors that offer a great way to seek the returns of an index. In the UK the most basic form would be a FTSE index tracker. This is simply a fund that will buy shares in all of the 100 companies that make up the FTSE 100 index (in the right market capitalisation weighted portions) so that the funds values and returns closely reflect the index itself.

Benefits of index investing

The main benefit to investors are those associated with economies of scale. By pooling their assets in the fund, investors are able to gain access to investments with the very low transactions costs that come with making large scale transactions.

In addition these large funds will have access to less liquid markets and products that are out of the scope of the average small investor. As a by product of this mutual funds help investors to diversify their investment portfolios. This happens because by investing in a fund, they are investing in all of the stocks or bonds the fund invests in. By investing in a wider range of investments, investors reduce the risk profile of their portfolio.

Another key reason why many choose to invest in mutual funds is that they do not need to worry about analysing and performing an investment appraisal on each and every stock or bond. Each fund will have a paid fund manager who will make such decisions on behalf of the funds owners (the investors).

Types of mutual fund

There are literally thousand and thousands of mutual funds in the market to choose from so choosing one can be a daunting task. The first step is to try to define your risk profile (how much risk you want to take), then try to find a fund that matches.

Equity Funds

This is probably the most popular type of fund. As the name suggests they invest in a portfolio of equity stocks or shares, however within this category each fund will have a different strategy.

Different funds will target different sectors or geographical locations. For example some funds target emerging economies such as those in South America or Eastern Europe – the rewards from these are typically higher than in the US or Western Europe however the volatility and risk are higher.

Another strategic objective will be whether the fund aim to achieve growth (an increase in the share price or value of its investments) or income (a constant stream of income that it will receive on a regular basis). If a fund chooses to focus on income it may tend to invest in high yield bonds or companies with a high dividend payout (which tend to be well established, stable businesses) as opposed to younger, riskier companies, perhaps with lower profits but the potential to grow over time.

Bond/Income Funds

As touched on above these funds will invest primarily in government and corporate debt products (gilts, bonds, treasury bills, fixed income products – they have many names). The aims of such funds are to invest in products that will provide a steady stream in income back to the investors. By their nature they tend to be less risky than equity funds.

This low risk characteristic does not always hold true however. Some funds will invest in high yield bonds or junk bonds (bonds issued by companies that have a much higher risk of default) that are much more risky. In addition all bond investments tend to be exposed to interest rate risk. In rough terms if interest rates rise, the value of bonds goes down because investors will instead be purchasing newly issues bonds which will pay coupons related to the new higher interest rates.

Summary

Mutual funds offer many benefits to potential investors such as diversification, access to illiquid investments or investments with prohibitive transaction costs. On the other hand, as with any investment, the available options can be confusing. As with any investment you should make sure that any investment in a mutual meets your risk profile and overall investment strategy and ensure you conduct thourough research before committing to invest.